Last Updated on Sep 1, 2021 by Manonmayi

How do you pick mutual fund schemes for investment? Ask most investors and they would say that they compare the historic returns and then pick schemes that offer the highest returns among their peers. But how exactly is a mutual fund return calculated?

When it comes to mutual fund returns, you would come across two main terms that depict such returns – CAGR and XIRR. Though these terms look technical, they are quite simple if you try to understand what they are. 

While many confuse the two to mean the same, CAGR and XIRR are quite different. When comparing mutual funds, you need to know which return you should compare for choosing the right scheme. So, let’s understand what these two terms mean, how they differ, and which is applicable when.

This article covers:

What is CAGR?

CAGR is the abbreviation of Compounded Annual Growth Rate. It is the most basic tool in measuring the return generated by a mutual fund scheme. The CAGR shows the average annual returns of a mutual fund investment over a specified period. So, if you invest in a mutual fund scheme over five years, the CAGR would depict the average rate of return that the scheme yielded every year for the past five years.

CAGR is calculated using the following formula:

CAGR = [(Value of the fund at the end of the tenure/value of the fund at the beginning) ^ 1/n] – 1

In the formula, ‘n’ is the tenure

So, if you invest Rs 5 lakh for five years after which the value of your investment is Rs 7 lakh, the CAGR would be calculated as follows:

CAGR = [(7,00,000/5,00,000)^⅕] – 1 = 6.96%

So, this CAGR shows that your investment of Rs 5 lakh earned an average annual return of 6.96% for five years, to amount to Rs 7 lakh at the end of your investment horizon.

Application of CAGR

CAGR is a quick way to check the returns of your mutual fund investments. When you compare different mutual fund schemes, their CAGR is the usual figure which is expressed as the return over different periods, like 3 mth, 6 mth, 1 yr, 3 yrs, and other time frames. CAGR is an effective way to determine the returns for a lump sum amount of investment for a specified tenure.

Limitations of CAGR

CAGR does not give an accurate historic return in the case of multiple investments during the tenure. If you are investing in one lump sum, you can calculate the CAGR to know the return yielded by your investment. However, if you are investing haphazardly in instalments or you choose the SIP mode of investment, CAGR may not give you the correct returns. In that case, you would have to calculate using other measures to get the correct return generated by your portfolio.

Moreover, CAGR averages out the returns over the tenure. It does not show the actual return that you might have earned in one year. So, in the above calculation, the CAGR of 6.96% does not mean that the actual return of the fund was 6.96% every year. It might have been higher in some years and lower in others. The rate of 6.96% is the average compounded rate of return, not the actual return year on year.

What is XIRR?

XIRR, abbreviated for Extended Internal Rate of Return, is the measure that depicts the returns earned by your systematic investment plans. In the case of SIPs, you make staggering investments rather than in lump sum. Even if you make haphazard investments at different time periods, XIRR would give the correct returns for such investments. 

XIRR is nothing but the aggregated CAGR of each instalment of investment. So, if you invest in a SIP for 12 mth, XIRR would be the CAGR of the last instalment (for 12 mth) + the CAGR of the second last instalment (for 11 mth) and so on.

Application of XIRR

XIRR is applicable in the case of periodic investments when the duration of each instalment varies. So, in SIPs, each instalment is invested for a month less than the previous. As such, XIRR gives the aggregate CAGR of each instalment. Similarly, over a one year period, if you invest in the 3rd mth, 5th mth, and the 10th mth, XIRR would be the aggregate CAGR of each investment wherein the ‘n’ would be 9 mth, 7 mth and 2 mth for the investments, respectively.

The difference between XIRR vs CAGR

Both XIRR and CAGR measure returns but their applications are quite different. Here are the main differences between these two types of returns:

It is the average compounded return of a lump sum amount of investment It is the aggregate CAGR of multiple investments done over a period of time
It is suitable only for a lump sum investmentIt is suitable for multiple cash flows/instalments done at different intervals of time
It gives the absolute return over a period of timeIt gives annual returns only 
The tenure does not changeThe tenure differs based on the investment done at different times

XIRR vs CAGR – which one should you choose?

Your choice between XIRR and CAGR should be dictated by your investment. If you are investing in a lump sum, the CAGR would give you the return earned from your portfolio. In the case of SIPs or periodic investments, XIRR would give a more accurate picture. So, choose between these two returns based on how you invest.

Be a mindful investor when picking a mutual fund scheme. Understand how you should check the returns of the scheme. Use the CAGR or XIRR rates to assess your portfolio so that you can make the right investment decisions of either investing in a scheme or exiting from it depending on the returns generated.